The SEC Fumbles a Crucial Post-Crisis Battle

And so we've marked a defining moment:
Securities and Exchange Commission Chairman Mary Schapiro's
hard-fought effort to re-regulate money market funds was the
first real litmus test of the agency's approach to individual
investor protection in a post-financial-crisis world.

And so we've marked a defining moment:
Securities and Exchange Commission Chairman Mary Schapiro's
hard-fought effort to re-regulate money market funds was the
first real litmus test of the agency's approach to individual
investor protection in a post-financial-crisis world.

Since Schapiro was unable to muster the needed votes from
the SEC commissioners, Wednesday proved to be a tough day indeed
for investor protection.

Today money market funds are valued at 100 cents on the
dollar day in and day out, representing an implicit guarantee to
return those full funds to investors on demand. Schapiro
proposed either allowing that value to "float" -- to represent
the true underlying value of the investments held -- or
requiring the funds to hold capital backing as "insurance" for
the funds' implicit guarantee of the 100 cents as well as to
hold back some customers' money for a period in times of
financial stress.

Many of the facts are clear: Money funds are a $2.6 trillion
market, representing an important investment vehicle for
individual investors, who believe that this money is as good as
cash. They hold this belief in good part because, in addition to
the unwavering 100 cents on the dollar they see, these funds are
shown in the cash section of their brokerage accounts.

Despite this representation, these funds are not fully safe
(though certainly safer than they were historically, given
investment restrictions the SEC put into place after the
financial crisis). But without risk, there is no return, and
thus these funds are invested in a variety of risk-bearing
securities. These include securities issued by European banks,
few people's idea of low risk over the past few years.

The sponsors of money funds include large, well-capitalized
financial institutions that arguably have the resources to bail
out these funds if the need arises. But they also include asset
management firms, which by their nature have no significant
capital buffers to support the funds in the event of a downturn.
The largest of these asset management firms fought the
additional safeguards most vigorously.

In past periods of financial stress, when the vulnerability
of money funds became clear, they have been subject to violent
"runs on the bank," with institutional investors recognizing the
challenge and getting out first, then individuals. Such a run
occurred in 2008.

But those who define that scenario as a worst case for
financial markets and thus for money funds, with only one fund
"breaking the buck," should note the extreme measure the SEC
took of guaranteeing money funds with a stabilization fund -- a
course of action that has now been prohibited by Congress. It is
an ugly, ugly parlor game of "what if" had that backstop not
been available.

The money fund industry spent millions of dollars in a
high-profile campaign against the proposed additional SEC
regulations -- which is their right. They argued that the
changes put in place since the downturn should be allowed to
burn in. They argued that the implicit nature of the guarantee
is clear in the prospectuses sent to investors (which individual
investors readily admit they do not read or particularly
understand). They argued that any changes in the funds could
lead to the money fund industry contracting and even
disappearing, and that the follow-on impact would be lost
American jobs. And while this was not part of their argument, it
was also clear that putting capital behind money funds feels
expensive (as insurance always does before one needs it) and
that the timing was inconvenient given that profitability is
under pressure from the low-interest-rate environment. Finally,
they argued that individual investors report that they don't
want their money funds changed in any way.

These arguments won the day -- even though none of them,
including giving investors what they want (or, in this case,
what they erroneously think they have), are part of the SEC's
mandate. Investor protection is, however, part of that mandate.

Now that one post-crisis litmus test has come and gone,
another looms. The baton is passed to the Financial Stability
Oversight Council, established by Dodd-Frank and charged with
ensuring the stability of our nation's financial system. This
council, chaired by Treasury Secretary Tim Geithner, can choose
to designate the money fund industry or individual funds as
"systemically important" and recommend that the SEC act or bring
them under the oversight of the Fed.

It is hard to believe that the FSOC won't declare a $2.6
trillion industry -- which carries implicit guarantees to
individual investors without capital backing and has been
subject to destabilizing runs -- as systemically important.
(This is perhaps almost as hard to believe as the notion that
re-regulation of this industry does not further the goal of
investor protection.)

We've had our first significant data point on the
regulators' approach to investor protection in the
post-financial-crisis world. Now we have the opportunity to mark
how well we learned the downturn's crushing lessons on systemic
risk. Watch this space.

(Sallie Krawcheck is the former CEO of Merrill Lynch Wealth
Management, former CEO of Smith Barney, and former CFO of
Citigroup.)